by Kevin Schofield

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This weekend’s read is a white paper issued recently by the Federal Reserve Bank, pondering whether the Fed should create its own digital currency similar to Bitcoin.

The Federal Reserve plays several critical roles in the country’s financial system. It issues paper and coin currency, backed by the country’s assets. It also serves as a “bank for banks”: Commercial banks keep accounts with the Fed and use them to enable large transfers between each other using the Fed’s central clearinghouse mechanism; the Fed also loans money to those commercial banks. It controls the country’s monetary policies, most notably the interest rates it charges to commercial banks, in order to influence economic growth, employment, and inflation. Finally, the Fed regulates and monitors commercial banks to ensure that the country’s banking system is safe and reliable.

The rise of digital currencies is an interesting new twist on the role of a central bank such as the Federal Reserve. Digital currencies aren’t that new; in a rudimentary form they have existed in online forms for many years, for example in online gaming environments where players can earn and/or buy points that can then be spent, traded, or given away. And apps such as Paypal and Venmo essentially maintain their own digital currency as well, from the point that money enters their system from the outside world until it leaves again.

Currencies, whether cold hard cash or in digital form, are all a form of “shared fantasy” in that they only carry value to the extent that we all agree that they do and agree on what that value is. International currency exchange rates represent the constant revaluing of a particular country’s currency, based upon its economic and geopolitical prospects. But for a digital currency such as Bitcoin, it becomes much more difficult to get agreement, and the wild fluctuations in Bitcoin prices serve to highlight that there is hardly consensus. Just this past week, former first lady Melania Trump tried to auction off a hat using digital currency but found that the winning bid deflated significantly in value overnight as the value of the currency crashed. Attempts to manage volatility has led to the creation of “stablecoins,” digital currencies whose value is tied to a specific real-world currency but generally require assets to be held in reserve to support that value.

Nevertheless, digital currencies have many attractions. They can dramatically reduce the cost and overhead of a financial transaction (as we see in apps such as Paypal) and especially for small “micropayments.”  They could potentially be more inclusive, opening up a wider range of online transactions to the estimated 7 million households in the United States that are unbanked, as well as the hundreds of millions of unbanked households around the world. Digital currencies could make cross-border payments easier, and they could provide a higher level of privacy.

On the other hand, many of those attractions could also be liabilities. Digital currencies may subvert governments’ efforts to police illicit financial transactions from organized crime and terrorist groups. They make it more difficult for central banks such as the Fed to regulate the financial system, and they make tax evasion easier. And the underlying cryptographic technology behind Bitcoin and other “cryptocurrencies” use a tremendous amount of electricity that largely goes unaccounted for as a cost of the system and also has significant climate impacts. 

The Fed, in its white paper, asks whether it should launch its own digital currency in an attempt to maximize the benefits while minimizing the liabilities. A Fedcoin, if you will, could provide stability by being pegged to the dollar and could even be managed as part of the central bank’s overall currency and backed with federal assets. One assumes that every commercial bank would have an account with the Fed that carried a Fedcoin balance and could be used for inter-bank transactions. The Fed would need to decide whether it wanted to go with a Paypal-style model, where it also maintained accounts for any U.S. resident and company, or a Bitcoin-style approach using blockchain technology that is more akin to cash where transactions are decentralized.

The Fed’s white paper asks a few other challenging questions, such as whether its digital currency could work “offline,” allowing for transactions in places and times where there is no available connection to the Internet — the way cash currency does now. It also pokes at the privacy questions: If the Fed is mediating financial transactions in its currency, does that give the federal government even more ability to track every aspect of our lives? Moreover, does it give the IRS access to our financial transaction history, and any balance we might maintain directly with the Federal Reserve?

The white paper answers none of these questions, nor does it set out to do so. It’s positioned more as a thought exercise, and it emphasizes that the Fed wouldn’t move forward to create its own digital currency “without clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law.” But it does point out that the rise of both payment apps and digital currencies present both opportunities and challenges for our country’s central bank, and almost certainly for every other nation’s central bank as well.

Money and Payments: The U.S. Dollar in the Age of Digital Transformation

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📸 Featured Image: Photo by BBbirdZ/Shutterstock.com

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